How the Euro Works

In addition to the membership requirements of the EU, countries who wished to participate in the euro and be a part of "Euroland" had to pass some economic tests referred to as convergence criteria:

The country's annual government budget deficit (the amount of money it owes) cannot exceed 3 percent of gross domestic product (GDP, the total output of the economy).

The total outstanding government debt (the cumulative total of each year's budget deficit) cannot exceed 60 percent of GDP.

In order to push down inflation rates and encourage more stable prices, the country's rate of inflation must be within 1.5 percent of the three best performing EU countries.

The average nominal long-term interest rate must be within 2 percent of the average rate in the three countries with the lowest inflation rates. (Interest rates are measured on the basis of long-term government bonds and/or comparable securities.)

The country's exchange rates must stay within "normal" fluctuation margins of the European Exchange Rate Mechanism (ERM) for at least two years.

While there was much debate over how strictly these requirements must be upheld, it was finally determined that participating countries must show that they are at least "on course" to meet the requirements.

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Meeting the initial requirements, however, is not a one-time thing. The Stability and Growth Pact, which was drafted in 1996, established an agreement stating that fines would be charged to countries who have excessive deficits. Member states cannot run a budget deficit that is greater than 3.0 percent of the GDP. If they do, they will be charged 0.2 percent of their GDP, plus 0.1 percent of the GDP for every percentage point of deficit above 3.0 percent. The Pact does not automatically impose these fines, however. Countries that are in recession, which is defined as a fall by at least 2.0 percent for four fiscal quarters, may automatically be exempt. A fall by any amount from 0.75 to 2.0 percent requires a vote by the EU to impose the fine.

While the Pact is structured as a stabilizer for the economy, there are still those who argue that it can be damaging to economies in that governments can adopt a loose fiscal stance during times of fast growth, but put the brakes on excessively during slowdowns.